Economic & Market Perspective: February 2023

2022 was a turbulent year for both the equity and bond markets. For the first time in the last 40 years, the stock and bond markets both declined by double-digit percentage points. The S&P 500^® Index finished the year down 18.1%. This is just its third annual decline since the Global Financial Crisis 14 years ago, and a painful reversal for investors after the S&P 500 gained nearly 27% in 2021. In the last four decades, only 2002 and 2008 were worse than 2022. All told, the Index lost $8.2 trillion in value, according to the S&P Dow Jones Indices. The Nasdaq composite, with a heavy concentration in growth companies, suffered an even bigger loss of 32.5%, and the Dow Jones Industrial Average posted a 6.9% loss for 2022.

The markets struggled all year as inflation hit a 40-year high, prompting the U.S. Federal Reserve to embark on its most aggressive tightening cycle in decades. Central banks raised interest rates at a historic pace not seen since the 1980s to fight high inflation. The Fed’s aggressive rate hikes remain a major focus for investors, as the central bank walks a thin line between raising rates enough to slow the economy, but not so much that its actions push the economy into a recession.

At the beginning of 2022, the Fed’s key lending rate stood at a range of 0% to 0.25% before it raised rates seven times to close the year at a range of 4.25% to 4.5%. Currently, the Fed is forecasting that rates will reach 5.0% to 5.25% by the end of 2023. Additionally, its forecast does not call for a rate cut before 2024.

Meanwhile, ongoing supply-chain issues, combined with Russia’s continuing invasion of Ukraine, worsened inflationary pressures as prices spiked for oil, gas and food commodities. Oil closed the year at $80 per barrel, about $5 higher than where it started the year; however, oil jumped to a high of $123.70 a barrel during the year, which helped energy post the only gain among the 11 sectors in the S&P 500 during 2022.

A different concern was China, which spent most of the year imposing strict COVID-19 policies, slowing demand for raw materials and goods. Recently, its government began lifting travel and other restrictions. It is unclear what the impact will be on the world economy as China tries to reopen its own economy in 2023.

The Fed’s battle with inflation will likely remain the most important issue for both Wall Street and Main Street in 2023. Investors will continue to focus on whether inflation is easing and if the Fed can guide the economy to a soft landing.

Mutual of America Capital Management LLC believes that volatility will remain elevated during the first half of 2023. The major issues that we are watching include the Federal Reserve’s ability to tame inflation and avoid a recession, the job market, corporate earnings and the ongoing war between Russia and Ukraine.

Stocks Rallied Late; Not Enough to Save 2022

The S&P 500 and the Dow posted strong results in the fourth quarter, with gains of 7.5% and 16.0%, respectively. International markets were particularly strong, as a weaker U.S. dollar in the quarter helped the MSCI EAFE Index return 17.3% during this period. Even with a robust fourth quarter, equity markets only modestly diminished losses for the full year.

As noted above, for the full year, the S&P 500 declined 18.1%, the Nasdaq slumped 32.5%, and the Dow fell 6.9%. During the same period, the Russell 1000^® Value Index (down 7.6%) outperformed the Russell 1000^® Growth Index (down 29.1%) by 21.5%. Given that higher interest rates make future earnings less valuable, it was not surprising to see the value sector continue to outperform the growth sector among large-cap and small-cap equities.

Bond Prices Under Pressure

In 2022, the U.S. bond market suffered its worst year on record, with bond indices down anywhere from 5% to 30%, depending on credit quality and maturity. The Fed lifted interest rates an astonishing 400 basis points, one of the fastest and most aggressive rate-hike cycles in history. This was in an effort to combat inflation, which peaked in June at 9.1%, its highest rate since the early 1980s. As Edward McQuarrie, professor emeritus at Santa Clara University, said, “Inflation is, in short, kryptonite for bonds.”

For the year, interest rates across the Treasury yield curve increased anywhere from 206 to 457 basis points. The projected pace of monetary tightening, along with hawkish rhetoric from the Federal Open Market Committee (FOMC), has induced a flattening of the yield curve. The spread between 2-year Treasury and 10-year Treasury yields narrowed by 181 basis points, creating an inverted yield curve of 55 basis points. Sometimes, this can be a precursor for potential economic weakness. On December 14, in the Fed’s ongoing quest to bring down inflation running near its highest levels since the 1980s, the central bank approved its seventh rate hike of the year and its second consecutive 0.50-percentage-point rate hike, bringing the Federal Funds Rate up to a range of 4.25% to 4.50%.

In 2022, the 10-year Treasury rose 237 basis points, to 3.88%, after finishing 2021 at 1.51%. With interest rates rising aggressively, bond prices fell during the same period. The 10-year Treasury fell 16.3%, the 30-year Treasury declined 33.5%, the Bloomberg U.S. Corporate Bond Index fell 15.8%, and the Bloomberg U.S. Aggregate Index declined 13.0%. It’s worth noting that bonds finished in both 2022 and 2021 with negative returns; it is extremely unusual for bonds to have negative returns in back-to-back years. The last time that happened was in 1958 and 1959.

One silver lining in the fixed income market is that yields on bonds, in absolute terms, are the highest they have been since the Global Financial Crisis. Looking at the U.S. Treasury yield curve, the 2-year note is yielding 4.43%; at the start of 2021, the same instrument was yielding 0.73%. In other words, there is more income in fixed income than we have seen in quite some time.

High Inflation Eases, but Persists

Taking a closer look at inflation, it continues to be problematic in the U.S., and its persistent rise is caused by a variety of factors. These include increases in global commodities, ongoing consumer demand, wage pressures for employers, and lingering supply-chain issues. The December readings for all three well-known inflation gauges continued to show levels well over the Fed’s average target of 2.0%: 1) The Bureau of Economic Affairs’ Core Personal Consumption Expenditures, the Fed’s preferred inflation gauge, was up 4.4% year over year; 2) the Producer Price Index, which sometimes predicts the direction of consumer prices, was up 6.8%; and 3) the Consumer Price Index (CPI), the most widely recognized gauge, was up 6.5%. The CPI provides a statistical measure of the average change in prices in a fixed-market basket of consumer goods and services. The December CPI marked the 21st consecutive month that inflation was above the Fed’s target rate.

Higher Rates Starting to Cool Economy

There are segments of the economy that have begun to show signs of lower prices as interest rates have risen, which should help ease inflation during 2023. The most visible area is a slowdown in commodity prices—especially gasoline, which was in a downward trend since peaking in June above $5. At the end of the year, the national average was $3.32 per gallon, slightly below the price a year ago of $3.40.

Looking at housing, existing home sales have stalled, and are down for 10 consecutive months and 35% below levels from a year ago, according to the National Association of Realtors. Existing median single-family homes peaked in June and have been down for five consecutive months. Mortgage rates are the leading cause of the sluggishness in housing. During 2022, the 30-year fixed mortgage rate started 2022 at 3.1% and rose to a peak of 7.1% before backing off to 6.4%.

The ISM manufacturing index or purchasing managers’ index is considered another key indicator of the state of the economy, as it measures the amount of ordering activity at the nation’s factories. The first reading in 2022 was 58.8 and, by December, it had weakened considerably, contracting by almost 10 points to 49.0.

In other areas, such as shipping and the automotive sector, sales have started to fall as well. Shipping rates have tumbled as consumer demand for goods has softened. The World Container Index, compiled by Drewry Shipping Consultants, was down 77% in 2022. A combination of higher prices, limited supply and higher financing costs has slowed new vehicle sales. For the full-year 2022, auto sales are projected at 8% lower than 2021 sales and 20% lower than their peak in 2016.

No Slack in the Labor Markets

The Fed is laser-focused on lowering inflation to its 2% target, and to do so, it must tighten monetary policy enough to create slack in the labor market. The nonfarm payroll report for December 2022 contained evidence that the labor market is cooling to a degree, but there is still work to be done. December’s change in nonfarm payrolls came in at 223,000, which was slightly above the consensus estimate, but considerably less than the previous 12-month average of 375,000. Fed officials were most likely encouraged to see average hourly earnings on an annual basis drop to 4.6%, from 4.8%. Going in the other direction, the overall unemployment rate dropped to 3.5% at the end of 2022 and dropped to 3.4% in January, which represents a 50-year low. Even with historic rate increases over the course of 2022, the labor market is still too tight from the Fed’s perspective, which means that the Fed will need to continue to raise interest rates, though at a slower pace and with modest increases compared to 2022, and proceed with quantitative tightening as 2023 progresses.

Looking at the demand side, the Bureau of Labor Statistics’ Job Openings and Labor Turnover Survey (JOLTS) for December showed that the number of job openings nationwide was 11 million. This is an indication that the labor market is tight, with a greater supply of jobs than demand for jobs. The Fed is trying to avoid wage-price spiral inflation, in which higher wages will eventually be passed on to consumers from companies needing to pay more to workers. A key to taming inflation is for the Fed to slow the job market, but to do so in a controlled way so that the unemployment rate does not spike meaningfully.

The Federal Reserve Must Tame Inflation

Since the beginning of 2022, the Fed switched from what had been an extraordinarily accommodative monetary policy to a hawkish stance. This more aggressive position was reaffirmed in August at the Jackson Hole Economic Policy Symposium. The Fed hiked interest rates at seven straight meetings in 2022, making it the most active Fed since 2005. The U.S. central bank current forecasts show rates will reach 5.0% to 5.25% by the end of 2023 and do not call for a rate cut before 2024. With the Fed’s more aggressive stance on tightening monetary policy to combat inflation, it is more likely that the economy will contract and employers will pull back hiring in response. When the Fed first spoke about bringing prices down, it had hoped to achieve a soft landing and not induce a recession.

Estimates for the balance of 2022 indicated that the Gross Domestic Product (GDP) will show modest growth, ending the year at 1.9%. Economists’ forecasts for 2023 now expect the GDP to show only modest growth of 0.5%, and these forecasts predict a 65% chance that the U.S. economy will enter a recession during 2023.

Strong Dollar Hurts Earnings

One of the consequences of raising interest rates to fight inflation is that the U.S. dollar has soared, relative to other currencies. According to Bloomberg’s Dollar Spot Index, the dollar strengthened 8.2% during 2022, peaking on September 27 at $114.106. The majority of the dollar’s move upward occurred between June and November, when the Fed raised rates by 75 basis points at four consecutive meetings. The dollar’s strength, relative to other currencies, puts financial pressure on other countries around the world, increasing the cost of imports priced in dollars and of servicing dollar-denominated debts. This is particularly difficult for emerging countries that have accumulated large quantities of dollar-denominated debt in recent years. Another consequence of a strong dollar is that it hurts U.S. multinational corporations that need to exchange their international sales back into dollars. Within the S&P 500, approximately 29% of sales come from non-U.S. countries. This will be a drag on earnings for these companies and could lead to lower earnings expectations.

Equity Valuations Contracting

The revaluation of equities is a function of high inflation and the Fed’s aggressive response to lower inflation by slowing the economy. As a result, investors are requiring a substantially higher risk premium due to higher interest rates and heightened economic uncertainty. Higher rates are causing equities’ price-to-earnings (P/E) multiples to contract, as future cash flows are less valuable when discounted to their present value. This is especially true for longer-duration assets such as growth companies. This rising interest-rate environment prompted investors to sell their high-priced shares of technology giants, such as Apple and Microsoft, as well as of other companies that flourished as the economy recovered from the pandemic. Amazon and Netflix each lost roughly 50% of their value, and Tesla and Meta Platforms each dropped by more than 60%. As a result, growth stocks have experienced a significant reduction in their P/E multiples. During 2022, the forward multiple on the S&P 500 Index contracted from 21.4 times at the start of the year to 17.6 times by the end of the year. During the same time frame, the 100 most expensive stocks fell from 43.0 times to 30.5 times, and the next 400 stocks fell from 17.2 times to 14.6 times.

While equity prices have fallen in 2022, it appears that valuations are beginning to price in the outlook for the economy. Domestic small-cap stocks appear most attractive, as they trade below both their historic P/E multiples and large-cap stocks multiples. The Russell 2000 has not traded at this low of a relative valuation to the S&P 500 since the early 2000s. As a comparison, the Russell 2000 outperformed the S&P 500 by more than 50% over the five years (2002–07) after the dot-com bubble in the early 2000s.

While 2022 was a difficult year for investors, it did help flush out some speculative excesses. SPACs, so-called meme stocks and “zombie” companies, all got wiped out. Notably, the crypto markets plummeted from $3 trillion in value to less than $1 trillion.

Outlook

The financial markets continued to experience downward swings in prices due to the heightened level of uncertainty in 2022. As a result, the overall short-to-intermediate outlook remains uncertain, and there are several issues impacting the markets and economy worth keeping an eye on through 2023. Perhaps most crucial will be actions taken by the Federal Reserve, which appears committed to continuing to raise interest rates to lower inflation.

At the moment, higher interest rates are starting to work their way into the economy. On the positive side, the impact of these higher interest rates are showing, with reduced prices and costs in areas ranging from gasoline to commodities, to auto sales and the housing market. On the negative side, inflation continues at levels not seen in decades, and continues to have a significant impact on persistently high food prices and wages, and increased medical costs. Additionally, the labor market is still too tight, from the Fed’s perspective.

With all of this in mind, the Fed clearly recognizes that inflation is a major problem, and it is expected to use all the tools in its arsenal to cool the economy and engineer a soft landing, while avoiding a recession. We will continue to monitor this and other important issues that might impact our outlook in the coming months.

Stephen Rich is the Chairman and CEO of Mutual of America Capital Management LLC.

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The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

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